Ethiopia On Bringing The Private Sector In

Ethiopia’s ruling party announced moves towards privatization of its strategic State Owned Enterprises (SOEs).  Is this a departure from its main developmental state strategy? Why did Ethiopia invest in SOEs in the first place and why consider privatization now? What can Ethiopia hope to achieve from privatization? And how must it move forward?

Ethiopia is in the midst of significant changes in many ways. Recently, the ruling party, EPRDF announced its intention to fully or partially privatize state owned enterprises in some strategic sectors.  While attempting to understand this decision, it is crucial to consider the contextual background.  Two decades ago, Ethiopia was a desperately poor economy with little to offer the world.  While devising its vision and objectives, the ruling party identified poverty as the core challenge at the root of all the country’s problems.  It thus decided that is objective as a government would be to ensure fast and equitable growth to eradicate extreme poverty and to reach middle-income status by 2025.  It was clear to the leadership that the small local economy could not deliver the required growth and bring about prosperity.  The only way to do so would be to build the ability to compete and win within the vast markets of the global trading system.  So the goal became, and continues to be, to build a market and private sector led economy fully integrated in the world.  In fact, former Prime Minister Ato Meles Zenawi was once quoted saying “we are building ነጭ ካፒታሊዝም “(White Capitalism).

Building a globally competitive economy offered daunting challenges.  Ethiopia needed a healthier and educated population.  It required massive building of physical infrastructure that could reduce transaction costs of any industry that could hope to compete globally.  The EPRDF decided that the developmental state strategy, as successfully operated by the East Asian Tigers (South Korea, Taiwan, Singapore, Malaysia, etc.) offered the best chance for Ethiopia to achieve its goal.  Starting from very low bases, these countries achieved economic growth unparalleled in human history with relatively good equity among the population.  The model broadly allowed for state direction and involvement in the economy, especially where pervasive market failures prevented good economic outcomes for citizens.  However, while initially allowing for significant role for the state, the model’s end goal is always to build a globally integrated private sector led market economy.   This is in contrast to the planned statist socialist approach as practiced by the Soviet Union in the 1950s. That approach had initially delivered some of the fastest economic growth rates in the world but contributed to that state’s implosion in the end.  In contrast, in the most successful Asian Tigers, Singapore, Malaysia, China, Korea, Taiwan, the state embraced the private sector and global markets and as a result transformed their economies within a few decades.  They devised practical and dynamic policy tools that solved economic challenges as they appeared.

Dani Rodrik, economist at the John F. Kennedy School of Government at Harard University, has in a number of studies argued that state intervention was important in the East Asian growth miracle.  He has argued “it is impossible to understand the East Asian growth miracle without appreciating the important role that government policy played in stimulating private investment”.  The key is that state involvement was targeted at enabling a globally competitive private sector that operates in the country.  Ethiopia therefore wanted to be more like South Korea, Taiwan, China, and less like the Soviet Union.  Ethiopia thus embarked on massive state led investment in human and physical infrastructure that has fueled growth rates even faster than those achieved by most of the East Asian Tigers.

Why did Ethiopia invest in SOEs in the first place?

The amount of investment needed to upgrade physical and human infrastructure in Ethiopia is massive.  The state reasoned that the local private sector did not have the capital or know-how to build the economic infrastructure necessary to compete in global markets.  New York University (NYU) economics professor William Easterly, who is known for this championing of market solutions to development and his strong dislike for state and donor interventions, agreed.  Having done an analysis of the Ethiopian economy in 2004, he concluded that Ethiopia seemed to be caught in a poverty trap that may not allow market solutions alone to solve developmental problems.

Thus, the Government argued that public companies, run on a commercial basis and aiming for maximum efficiency could play a useful role in the then small and underdeveloped Ethiopian economy.   In particular, such public companies can play a positive or even necessary role in sectors with high positive spillovers and where the capital investment or required sizes to reach the necessary efficiencies are large.  Therefore, in sectors like air transport, shipping, etc. domestic private companies may not have the necessary size or know-how, and foreign companies may not be interested or may not be reliable providers.  Further, foreign investment in infrastructure, even if successfully attracted, also required returns on capital that would end up making the infrastructure too expensive to use, and possibly rendering Ethiopia noncompetitive in crucial services such as power that are critical for industrialization.

Why consider privatization at this scale now?

Since those early fateful decisions to heavily invest in SOEs, these enterprises have driven Ethiopia’s economic growth of the last decade to a large extent.  The enterprises themselves have grown to become some of the largest such businesses within a continental perspective.  So, if state enterprises delivered such progress so far, why privatize them?

The best leaders in Asian developmental states understood that SoEs almost always delivered lower return on investment than private firms.  In 2007, Dollar & Wei found that wholly and partially state owned firms in China have lower average returns to capital than private or foreign firms by 11-54 percentage points.  They further stated that if China could raise the returns to capital on the stock of capital currently employed by state firms, then the country can reduce its very high investment rate by 5 percentage points without an adverse effect on its growth rate and, as a result, can raise its consumption and deliver greater improvement in living standards.  So as soon as developmental state economies started to become more sophisticated and the original reasons for creating SoEs began to wane, they brought in private capital.  But the challenge is the fact that there are no hard and fast rules as to when to begin this transition.  Often, it is economic challenges or crises that force a review of existing policies.

Ethiopia is no different.  In fact, Ethiopia may have gone a bit too far in relying on SOEs in the all-important sectors as a default position.  And more importantly, SOEs probably did too little to facilitate the entry and development of private sector companies in their respective sectors through contracting out, privatizing stakes, providing partnerships and franchisees or developing suppliers.  Rather, most appear to have attempted to monopolize supply and prevent competition from the private sector.  The state probably aggravated the situation further by channeling massive amounts of foreign loans and domestic credit to SOEs while limiting such opportunity to its private sector.  And with increasing investment under these conditions and the inability of the SOE sector to turn the investment at this scale into productive assets, it is clear that the state’s ability to singularly drive rapid growth is fast diminishing.  It is clear that the domestic and foreign private sector must now play a greater part in driving growth.  But the realization of this fact has probably come to pass due to the significant challenges facing the Ethiopian economy at the moment.

The Ethiopian economy, while holding much promise for further rapid expansion, is facing head winds.  Ethiopia’s phenomenal growth was driven by billions of dollars of investment, reaching nearly 40% of GDP.  This money was generated from domestic savings, massive external borrowing (facilitated by debt cancellation under the HIPC initiative), and donor financing.  Unfortunately, these sources of funding are no longer as readily available as before.  While national savings rates have increased to reach around 20% of GDP, there is still a massive resource gap of about 20% of GDP.  Tax revenue growth has stagnated in recent years.  And recently, the IMF categorized Ethiopia debt distressed economy, limiting its ability to borrow from abroad.  Cognizant of the dangers of indebtedness, the Government suspended all further commercial borrowings.  Similarly, the Government’s ability to borrow domestically has narrowed given rising inflation that has become politically unsustainable.  For Ethiopia to maintain current growth rates, it will need to invest around 40% of GDP.  This means the country will need to invest around $32 billion this year, a tall task for a nation facing financing challenges.

Further, quite a bit of this investment requires foreign currency to purchase.  Ethiopia’s inability to generate sufficient foreign currency means its investment in growth enhancing infrastructure is also threatened. Export revenues have stagnated for a better part of the last decade and it may just be the country’s real Achilles heel.  National foreign currency reserves have become dangerously low.  And despite many attempts at containment by the government, the parallel market premium has surpassed 20%, putting a damper on official remittance flows.  Ethiopia’s concessional and non-concessional borrowings have also started to mature.  The country will need up to $3 billion dollars a year to simply service its debts, an amount equal to annual export earnings.  But many of the projects state enterprises borrowed to develop are still stuck in the implementation process they are not ready to start paying back.

While these challenges are imminent, time is not on the side of policymakers.  They don’t have a few years to figure this out.  Nearly 70% of Ethiopians are under the age of 30, and creating jobs is a matter of urgency.  Years of SOE led growth, focused mostly on the service sector, has not delivered jobs on the scale (and value level) necessary to absorb Ethiopia’s overwhelmingly young population.  Despite more than a decade of rapid growth, the proportion of the Ethiopian population stuck in low value smallholder agriculture was only reduced by about 4 percentage points.   The desired growth in manufacturing has proved to be much more difficult to achieve.  At the same time, the aspirations of a healthier, better educated, and interconnected young population has gone beyond the Government’s realistic ability to deliver.

So why privatize now? Perhaps because the ability of SOEs to deliver growth has approached its limits.  More importantly, the Ethiopian state’s ability to self-finance or borrow from abroad has significantly been reduced.  Without such financing, the SOEs that drove much of the growth of the last decade cannot hope to expand at the same speed. Slow growth is certainly not an option given Ethiopia’s political economy and demography.  If it wants to continue to grow as planned, Ethiopia may not have a choice but to start financing much more of its growth through the private sector.  Luckily some of Ethiopia’s SOEs have become very profitable and valuable assets that can generate much needed money, and foreign currency without necessarily letting go of them entirely.  The interest from investors for some of these assets is likely to be intense.

Finally, it is worth reiterating that Privatization, as announced by the EPRDF is not a departure in economic development strategy.  Developmental states invest through the state with the ultimate goal of creating a market led system that delivers better and faster results for their populations.  Indefinite state ownership is never the goal.  Instead, developmental statistics are pragmatists who adjust their policies with the increasing sophistication of their economies. Privatization is nothing new to Ethiopia.  An ongoing privatization program has seen off more than 200 enterprises over the past two decades.  Recent privatizations in the brewery sector for instance have driven promising growth with backward linkage fueling further investments and linking straight to benefit smallholder farmers producing barley.

What can Ethiopia hope to achieve through privatization?

Given private firms’ better return on investment scenario, Ethiopia will in the long-term benefit immensely from a privatization done right.  In the midterm, Ethiopia’s move to engage private investors could help bring in tens of billions of dollars of necessary investment to fuel growth.  In fact, the positive publicity of an Ethiopian economy “opening up” could by itself drive foreign investment in totally unrelated sectors.  And much of this will deliver much needed foreign currency.  Ethiopia is already the second largest recipient of FDI in Africa (2017), all without allowing foreign capital in the sort of sectors that drive FDI in peer African countries, such as financial services, telecoms, transport, etc.  Further privatization into these sectors should thus make the country a magnate for more investments.

Ethiopia’s state enterprises have already borrowed billions of dollars to reach their current levels of development.  For instance, Ethiopian airlines has generated a robust $2.7 billion in revenue and $232 million in profits this year.  But it is also important to consider that its total debt reached 70% of its total assets (2015).  If SOEs are to fulfill their promise of becoming bonafide Multinational Enterprises with a continued role in driving Ethiopian growth, they will need financing, technology, and access to new markets.  Privatization, done right, could mean that enterprises like Ethio Telecom, Ethiopian Shipping Lines, etc. could start to expand into foreign markets and generate foreign currency the way Ethiopian Airlines is currently doing.  Ethiopian airlines itself, building upon the country’s advantageous location, can truly aspire to compete with the likes of Emirates and Qatar and turn Ethiopia into an air transport logistics hub with broader positive economic repercussions for the nation.  The airline’s current ambition of doubling its fleet by 2025 will be difficult without aggressive equity injection from the private sector.  Such emergence of Ethiopian multinationals is one prerequisite for transforming Ethiopia’s exports and creating millions of jobs through linkage to smaller domestic firms.  Ethiopia can hope to gain from increased revenues from these enterprises.  It can also hope to gain from broader efficiency in the rest of its economy likely to be created from further progress in these strategic sectors.

Privatization can also further free up the state’s ability to focus on other important issues like improving health and education.  It will also save cash by bringing in private capital to share in the cost of developing infrastructure.  The recent promulgation of a Public Private Partnership law has already led to a strong pipeline of private investors financing the generation of thousands of megawatts of energy using their own money.  Shifting the burden of financing towards the private sector could also allow the state to play more meaningful roles within the fast-changing Red Sea and Nile Basin geopolitical developments to further ensure Ethiopia’s rise as a regional power.  Prime Minister Abiy’s appropriate vision for integrating the Horn of Africa, perhaps following the example of the East African Community, could find additional driving forces.  For instance, the Government could save its money to crowd in more investment into new ports where they make the most sense (Djibouti, Lamu, Port Sudan, Somalia, Eritrea).

How should Ethiopia move forward?

All the possible positive outcomes that may accrue from privatization are not necessarily assured.  They can only be achieved if and when the Government’s implementation is well thought out and done within transparency.  Regulatory capacity must be beefed up and the proceeds from privatization must be invested wisely.

Transparency

While managed by the state, money invested in SoEs belongs to Ethiopian citizens.  It is money that must be carefully invested for the highest possible returns so as to improve the living conditions of Ethiopians.  Therefore, transparency in the privatization process becomes an important issue to consider.  In this, Ethiopia should seriously consider the establishment of a stock exchange.  In addition to increasing transparency, such an institution would allow Ethiopian citizens the ability to invest in these nationally prized assets and benefit from the returns.  The highly innovative Safaricom is partly owned by Kenyan investors in addition to foreign investors.

Beef up regulatory capacity

A main reason private firms deliver better efficiency and returns is due to the existence of a fairly regulated competition.  Therefore, privatization in Ethiopia must come with a consideration of further policy changes and strengthening of private sector regulatory bodies.  For instance, privatization of Ethio telecom without liberalization of the sector to trigger full competition could be tricky.  Trading a public monopoly for a private one is hardly progress.  Private monopolies are known for their inefficiency, lack of innovation, high costs and poor services.  So Ethiopia can hope for a better outcome by fully liberalizing the sector and selling additional licenses to other private operators. Doing so could generate more money but under competitive forces, better prices and better services could be expected.  For this to be ensured, the capacity of the Ethiopian Telecommunications Agency must be quickly raised.

Wisely invest proceeds & pick appropriate partners

As Ethiopia raises 10s of billions from privatization, it will be important for it to invest the proceeds in a manner that maximizes long term return on investment for the country.  Above and beyond solving short term challenges faced by the economy, privatization can help solve long term competitiveness issues at the heart of Ethiopia’s export development challenges.  As such, the state should also carefully analyze private sector partners for the capability and market access they bring in addition to their financial offers.  The Government should not simply be happy with those firms that approach it.  Instead, it should proactively research and engage those firms who bring the best complementary to Ethiopia’s SOEs.  The end result must be that these enterprises pave the way for the rest of Ethiopia’s economy to cross over and integrate in the global trading system.  Complementary

 About the AuthorHenok Assefa is the Managing Partner at Precise Consult International.  Precise is a leading economic development and investment advisory firm working to revolutionize the way business is done in Ethiopia.